ETF Trends
ETF Trends

Investors should consider small-cap exchange traded funds beyond ones that reflect the Russell 2000 Index as the popular benchmark’s shortcomings may cause it to underperform other indices.

The Russell 2000 Index has trailed the S&P SmallCap 600, MSCI USA Small Cap and CRSP U.S. Small Cap indices by over an annualized 1.4% from the end of June 2011 through January 2015, according to Morninstar analyst Alex Bryan.

The iShares Core S&P Small-Cap ETF (NYSEArca: IJR), which tracks the S&P SmallCap 600, has generated a 9.3% average annualized return over the past 10 years while Vanguard Small Cap ETF (NYSEArca: VB) returned 9.8%. In contrast, the iShares Russell 2000 ETF (NYSEArca: IWM) gained 8.5%. [Small-Cap ETFs: Slight Differences are Important]

Bryan argues that the Russell 2000 incurs implicit transactions that could undermine performance. Specifically, as the index rebalances its holdings all at once, the concentrated trades could impact the price of the underlying holdings, which cause a drag on overall performance.

“The Russell 2000 Index is one of the most widely followed U.S. small-cap indexes and reconstitutes itself on a single day each year,” Bryan said. “The resulting trading volume in the stocks that the index’s reconstitution affects could cause it to suffer from greater market-impact costs than its peers.”

Most investors have come to expect the Russell 2000 to effect changes at the end of May. The index provider would rebalance both its Russell 1000 and Russell 2000 in response to new market-capitalization weights. Consequently, investors can anticipate the actions of the Russell 2000 indexer to bid up prices on new additions and bid down deletions between the end of May and the effective changes in June.

A study conducted by Yen-Cheng Chang found a 5% increase in price among stocks in the Russell 1000 to be added to the Russell 2000 in June from 1996 to 2012. The study also revealed a 5.4% decrease in price among stocks to be moved from the Russell 2000 to the Russell 1000.

Index arbitragers have capitalized on the index changes by front-running trades. However, Petajisto argues that the arbitragers help smooth out transaction costs since index managers’ trades would cause sudden spikes without smaller players to build a market. Consequently, it may be Russell 2000 own fault for being too big as it causes such a large market impact on small, less traded stocks due to its concentrated turnover.

In contrast, the CRSP Index reconstitutes holdings on a quarterly basis and has a larger capacity than the Russell 2000 because of its wider market capitalization. Additionally, the S&P SmallCap 600 makes changes as needed, which allows the index to spread out changes.

Moreover, investors can consider the Schwab U.S. Small-Cap ETF (NYSEArca: SCHA), which tracks the Dow Jones U.S. Small-Cap Total Stock Market Index. SCHA reconstitutes holdings once a year, but its small asset base diminishes market impact on trades. The ETF also does not go as far up on market-cap as the Russell 2000.

For more information on small-capitalization stocks, visit our small-cap category.

Max Chen contributed to this article. Tom Lydon’s clients own shares of IWM.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.